Hamish McRae: Ominous signs that capital flows will be slow to recover

Economic Life

First, the Lehman collapse hit the rest of the banking sector. Then it hit international trade. Then the damage moved on through to industrial production. In the first three months of this year it devastated share prices. Now, a year on and after a huge effort of governments around the world to get credit moving and hence to rekindle economic growth, the world economy seems to be growing again.

But looking ahead there are great uncertainties. Up to now most people have focused on those issues nearest home, for obvious reasons. Here in the UK we are still desperately worried about still-rising unemployment and about the impact on the public finances. But what happens to the world economy, as opposed to the various national economies, including our own, is surely more important. More specifically, we cannot see the long-term impact on globalisation: whether the trend towards a more integrated world economy will resume or whether we have passed some high point that will be hard to reach again.

There are some ominous signs. World trade has declined and banks have pulled out of a lot of international business. But you would expect the former to recover as growth resumes, as it was in a sense artificially restricted by the lack of availability of trade credit, while international investment can continue irrespective of what the banks are or are not doing. During periods when the banks become less important as financial intermediaries, the capital markets tend to take up the slack.

So what is happening to international investment flows? The best annual survey of these is done by the United Nations Conference on Trade and Development (Unctad) and its new World Investment Report 2009 came out yesterday. The news is not good. Broadly speaking, there are two sorts of capital flows, portfolio flows and foreign direct investment (FDI) ones. Portfolio investment is buying shares or bonds; FDI is buying companies (or at least strategic stakes in them) and investing in plant and machinery abroad. The Unctad report focuses on the latter. As you might have expected, the decline in FDI that started last year continued into the early part of this year. More troubling, a significant recovery is not expected until 2011.

FDI hit a peak at the end of 2007, and has been in steady decline ever since. So it was actually falling in the first part of last year, even though the world economy was still growing. Overall, FDI inflows were down 29 per cent in 2008 compared with 2007. The US remained the largest recipient of such investment, but France and China have moved above the UK, which was in second position in the year before. In terms of outflows, the UK fell to number five, having been in second position in 2007.

From our own national perspective this is not very encouraging. The Trade minister, Lord Davies, who is in India at the moment, tried to put a good gloss on it, saying: "Despite the tough global conditions, the UK remains a strong and vibrant market, and global businesses recognise this."

But however you present the data, the fact remains that the UK has self-evidently become a less attractive haven for inward investment in relative as well as absolute terms. There is no doubt that the UK has signalled to the world that it is not so interested in inward investment. We look like losing about 20 per cent of the hedge funds to Switzerland, and a number of UK-registered companies, including WPP, are moving their legal headquarters abroad. When a massive advertising giant moves offshore, it advertises the fact that the UK has become a less attractive business location.

However, what matters most is what happens next internationally. There are a couple of broad trends. One is that cross-border mergers and takeovers declined notably. Multinational companies have been tending to sell overseas operations rather than buy them. Another is that investment in developing countries has fallen by less than in developed countries. For example, it seems that China still wants to invest in Africa, to control its access to raw materials. In percentage terms, Africa received the largest increase in inward investment over 2007, a rise of 27 per cent (thanks to a surge in the first quarter of 2008), while flows to Latin America were also up.

The Unctad report is inevitably a backward-looking one, but its views on the likely future trends matter. The two things that come through most strongly are the expectations of recovery and the shift of investment to the developing nations.

On the first, FDI totals in 2007 were $1.85 trillion; they fell to $1.7 trillion last year; they are expected to fall to below $1.2 trillion this year, before recovering to $1.4 trillion next year and $1.8 trillion in 2011 (see bottom graph). Assuming those estimates are right – and one of the many lessons of the past year is that you cannot assume anything with much confidence – that will mean that by 2011 we will still only just be back to the level of international investment reached in 2007. Is that a pause in this aspect of globalisation, or a reversal of the whole phenomenon?

My instinct is to say that it is more likely to be a pause, for three reasons. One is that we had a similar experience in the early 2000s. After the end of the dot.com boom, international investment collapsed in much the same way as it has now, but it did recover strongly as the growth phase gathered pace. The second is that investment in and from the emerging nations will continue to grow, irrespective of what is happening in the developed world. And the third is that there are huge investment funds around the world seeking a home, including in the sovereign wealth funds of the oil-producing nations. Most of the latter funds are portfolio investments, but expect the amount of direct investments to rise, as the sovereign wealth funds seek some management influence in their investments.

So in all probability, come 2014 and beyond, we will not only be back to the level of investment reached in 2007, but move well beyond it. What I think will happen, though, is for banks to play a smaller role in financing these flows. That will be a lasting legacy of the Lehman crash, and the associated pressures on the commercial banks. International banking is not going to disappear, but the commercial banks will all be more chary of doing cross-border lending, particularly if it involves complex instruments. Instead the scope for investment banks to choreograph cross-border mergers and for fund managers will increase.

However we all have to acknowledge that there is a possibility that this relatively optimistic view could be proved wrong and that the march towards an ever-more global world will be halted. We won't know until it happens, and then it may be hard to get the movement going again. So we should see this Unctad report as a warning signal. Cross-border investment is a good indicator of the health of the world economy, and it is flashing amber right now.